Five Fundamentals of Investing From Warren Buffett

Warren Buffett has previewed his upcoming annual investment letter via CNN Money.  He lists five investment elements and mixes in interesting stories to illustrate his points.  Here are the five: 

• You don't need to be an expert in order to achieve satisfactory investment returns. But if you aren't, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don't swing for the fences. When promised quick profits, respond with a quick "no."
• Focus on the future productivity of the asset you are considering. If you don't feel comfortable making a rough estimate of the asset's future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn't necessary; you only need to understand the actions you undertake.
• If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
• With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field -- not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
• Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle's scathing comment: "You don't know how easy this game is until you get into that broadcasting booth.")

I will be out on Friday.  See you next week!

Link:  Buffett:  What You Can Learn From My Real Estate Investments.

Taxes

I was asked after I posted my game plan piece a week or so ago why I often worry so much about the tax consequences of my trades.  I saw this piece in in Reuters linked below discussing mutual funds tax consequences.    Note the following from the article:

"Some actively managed stock funds at Vanguard Group, the largest U.S. mutual fund company, are paying gains approaching 10 percent of net asset value, Vanguard spokesman John Woerth said. He called that 10 percent range sort of the unofficial threshold for what might be considered a large distribution.

At BlackRock Inc, the $4.3 billion Capital Appreciation Fund plans to distribute gains to shareholders of up to 15 percent of the fund's average net asset value, according to the company's projections. And the distribution payout at the small BlackRock Large Cap Growth Retirement portfolio could top 60 percent, according to company estimates."

Gus Sauter in the Wall Street Journal notes. that "since taxes are inevitable and likely to become even more inevitable, investors should focus on after-tax returns.  You can't live off of before-tax returns".  

I don't want to wade into the the complex waters of capital gains here but  you can see a basic picture of what he's saying if you do the math.  A taxable account that started with $100,000 and ended the year with a value of of $130,000 shows a gain of $30,000 or 30%.  If that account shows net realized capital gains of $10,000 then the account is potentially subject to taxes between 10-40% depending on how these gains are classified and the income bracket of the account owner.  That has the potential to drag the return down to anywhere from 18-27%.  ETFs by themselves are more tax efficient than mutual funds.  That will not be of much use if there is a lot of turnover in a portfolio that generates in particular short term capital gains.  That's why it's  so  important to be aware of a client's tax situation before you start making large changes to a portfolio.  Without getting into specifics, I would like to think that my clients would be happy with their portfolio returns last year.  Of course returns were helped by an excellent environment for US stocks back then.  I think they'll be happier with those returns when they realize in most cases there won't be much of a tax impact to their bottom lines.  

2014 has the potential to be trickier in that regard and I want to make sure I do what I can to minimize any potential tax hits.  To echo Mr Sauter, at the end of the day, its not what you make that's the most important number.  It's what you keep.

Link:  Reuters: US Mutual Funds Hit Investors With Big Capital Gains.

Stock Price Targets

From Meb Faber Research here's a rundown of year end 2014 price targets for the S&P 500 from most of Wall Street's investment shops.

The herd seems to be congregating around that 1,950-2,000 mark.  Our current cone of probability is 1,900-2,100.  Wall Street was way low in their aggregate price targets last year.  Have to at least perk up a bit when everybody is in the same range with market's at the higher end of their valuation zones.

Link:  Meb Faber:  Stocks Up, Bonds Down.

The Great Rotation

Long time readers of this blog know that I'm a proponent of the "Great Rotation" thesis.  That theory says that longer term as interest rates stay low and as the crash of 2007-09 recedes in the public memory that a sizable amount of the dollars stashed away in money market accounts or bond funds will find their way back into equities.  I've talked a bit about this here and here.  

Where I perhaps differ from the herd is that I think this will be a longer process than perhaps many of the gurus that are its biggest advocates.  I think it could be a 5-10 year event and will be prone to periods of volatility where the money rapidly flees the markets for the perceived relative safety of cash or bonds.  

I think the market has less to worry about a financial bubble from an intense period of market speculation as long as so much money sits locked up in bond funds and money markets.  It's when that balance again gets skewed heavily towards stocks that I think we'll have to worry.  I saw evidence that I might be right when I found this twitter post by a fellow named Matthew Phillips.  Here's his link and below is the chart from Deutsche Bank that he posted showing the amount of money that fled the equity markets on January 13-14th.  

This chart tells me that we are a long way from the irrational exuberance type of environment that usually precedes a catastrophic market decline.  Not saying we can't have one or see a significant market correction.  But the public remains wary of the equity markets and as long as that "wall of worry remains in place, the less likely we are experiencing financial euphoria.

Hedge Funds More Bad Press

More press from the hedge fund world that doesn't particularly shed a great light on most funds/folks doing that type of investing.

Business Insider.com.  Warren Buffet's Hedge Fund Bet.

The Motley Fool.Com:  The Worlds Smartest Investors Have Failed.

Bloomberg.Com:  Hedge Funds Trail 60/40 Portfolio Mix.    "Before they discovered hedge funds, pension funds and endowments typically held portfolios with 60 percent in equities and 40 percent in bonds. Many would be better off if they had stuck with the old formula."

I will be out of the office tomorrow visiting clients so there will be nothing posted here until Monday.

Corporate Earnings

Corporate earnings continue to be a lynchpin for this market.  Here's what the folks over at Chart of the Day have to say about them.  {Green highlights to the author's text are mine.}

"With first-quarter earnings largely in the books (over 79% of S&P 500 corporations have reported), today's chart provides some long-term perspective on the current earnings environment by focusing on 12-month, as reported S&P 500 earnings. Today's chart illustrates how earnings declined over 92% from its Q3 2007 peak to Q1 2009 low which brought inflation-adjusted earnings to near Great Depression lows. Since its Q1 2009 low, S&P 500 earnings have surged to all-time record highs. To further illustrate the significance of the current corporate earnings recovery, consider that the run-up in real earnings from Great Depression lows to credit bubble peak took over 74 years. The run-up from financial crisis lows to today has been similar in magnitude (actually slightly more) but was accomplished in a mere five years."

*Long ETFs related to the S&P 500 in client and personal accounts at the time of this publication.  Please note that these disclosures can change at anytime.

Flyin Away!

I'm escaping "Chi-beria" for the long President's Day weekend.  Assuming the weather gods are with us it's time to find a place where warm temperatures aren't defined as high single digits on a thermometer.  I have roughly 3 feet of snow in my backyard and it's time to see some green grass!  Nothing here tomorrow through Tuesday.  Of course we'll break in if the need arises.  I'll remind you that the markets are closed Monday anyway.

Stay warm!!!!!

We've had snow with one little break since the beginning of December.  Snow's been now on the ground since right after Christmas so we're about 75 days and counting of the white stuff this winter….And Cold!

Time for some heat!!!

Six Financial Thoughts.

"Six Financial Maxims That You Should Rethink" from Business Insider.com and via LearnVest.com  This article is well worth the time, especially if you're younger and trying to develop a relationship between your life goals and money.  I'll list the six and a brief quote from most.  You need to go read the whole article at the link above!

1.  The more money I earn, the happier I'll be.  "Research shows that more money doesn't necessarily equate to more happiness….There is also research to show that what {you spend your money} on, specifically, influences your happiness too."

2.   My kids should be my financial priority.   "You have to be able to take care of yourself first, so you're able to take care of the kids."

3.  Debt is always bad.  "There is definitely good debt.  This is the money you borrow to pay for something you expect to increase in value over time."

4.  I should put off my life goals until I can afford them.  "Generally speaking, you should be saving up for longer-term money goals so you can create the life you want, without the cost taking you by surprise."

5.  Never Rent when you can own. 

6.  Money is the root of all evil.  "The truth is, money, on its own, isn't good or bad, its what you do with it that matters."  {I liked this one the best.}  

Game Plan

The  game plan is tactical and strategic allocation of our clients assets based on what the playbook tells us has historically occurred. It is further refined to the specific risk/reward parameters of our various client groups. In some situations,  portions of the game plan will be implemented across the board in all client accounts or in a specific investment category. At other times portions of the game plan can be specifically implemented in individual client accounts where events or certain client events may warrant such action.

We said the other day that the playbook suggests that the higher probability for the market over an intermediate period is likely to be a trend less consolidation period.  Recent trading action is suggestive of a market locked into a likely intermediate range between 1,730 and 1,845 on the S&P 500.  While anything can happen, historical probability would suggest that those recent highs should pose resistance to the market's advance at least the first time stocks again approach those levels.  

At the beginning of the year we reviewed all of our portfolio strategies and individual client mandates.  Within those strategies and mandates  certain ETFs we held needed to be rebalanced.  We began that rebalancing process in early 2014 and had not put those new cash levels back to work before the market began its most recent sell off.  We have redeployed some of that cash in the most recent decline. We plan, given what we know today, to become a bit more defensive as we approach those previous highs.  We have not finished our redeployment process and believe that we will be rewarded for patiently implementing these changes over the course of the next several months.  

One of the reasons we have taken our time is that there are certain tax implications to many of our clients if we would have raised more cash immediately this year.  Many investors will look at their portfolio returns at the end of the year and measure the gain without understanding their individual tax consequences.  What you make in the market is important but so is what you can keep away from Uncle Sam's clutches.  As such we try to be as tax neutral as possible. 

We are going to use what we believe as this consolidation phase as an opportunity to make some portfolio changes that were not available to us in a strong year like 2013.  Even if we become somewhat more defensive to the upside the closer we trade near resistance, we think we will have reasonable equity levels if we are wrong and the market resumes its advances higher.  We also have the defensive pages of the playbook nearby if events warrant a more defensive market posture.  

We very rarely discuss specific securities or asset changes we might have made on this blog. I will say however that in general we are increasingly becoming more attracted to foreign based ETFs, especially as these relate to emerging markets.   Beyond that general investment observation {an observation  we've now held for over a year which has also been very wrong}, please feel free to contact me personally if you would like more information on how we are investing in this environment.  

*Long ETFs related to the S&P 500, foreign based ETFs and emerging market ETFs in client and personal accounts at the time of this publication.  Please note that these disclosures can change at any time and we under no obligation to inform the readers of this blog if these positions should change.

Posting Issues

I'm having major internet issues today.  I'll try to put up the conclusion to yesterday's post later.  Look for it tomorrow if I can't get it out there the way I'd like.

an tSionna {02.08.14-Playbook}

Please note that the following discussion is based on my reading of the tealeaves and is a probabilistic assessment of what could occur.  It is based on what I am seeing today and could end up looking very foolish on a going forward basis.  There is therefore no guarantee that the scenario I'm painting will occur.  Also  I reserve the right to change my opinion at any time and reserve the right to do so without necessarily posting that change on this blog.  Investors that are not affiliated with Lumen Capital Management, LLC should consult your own investment advisers if you have one, do your own research or better yet, hire us before acting on any opinions you might see in this blog.  There are no guarantees.  With that out of the way, here goes……!

The S&P 500 as represented by it's major component ETF, SPY, in the chart above sold off around 7% in roughly a three week period.  We covered some of that here.   The market likely served us up a warning when it behaved in a different manner in early January than it has in the past several years.  Instead of rocketing out of the gate in 2014 like we've  seen in every year since 2009, the market pitched and stalled out.  Now readers know that I think part of that is because we stole some of 2014's gains in the last two months of last year.  However, stocks are in a different pattern now and I think we need to ponder what that might be telling us.

We never go anywhere without consulting our playbook.  The playbook is situational and probabilistic analysis based on historical market results. We use our studies of money flows along with the disciplines of fundamental and valuation analysis to see how markets have responded to similar historical events that we might currently be facing. The playbook will give us different market scenarios to current market activity. From the playbook we formulate a game plan.

The  game plan is tactical and strategic allocation of our clients assets based on what the playbook tells us has historically occurred. It is further refined to the specific risk/reward parameters of our various client groups. In some situations portions of the game plan will be implemented across the board in all client accounts or in a specific investment category. At other times portions of the game plan can be specifically implemented in individual client accounts where events or certain client events may warrant such action.

Today we'll discuss what the playbook is telling us and tomorrow we'll give you a tiny peak at the game plan.

We entered the year with stock valuations in no-man's land.  They weren't exactly at nose-bleed levels but the market was also not cheap like it had been in past years.  We covered market valuations back in January 17th.  This obviously began to bother the market.  Stocks will fall under their own weight unless there's buying power to move them higher.  Valuation plus some less than stellar economic news {largely related to weather in my opinion} and worrisome news out of emerging markets provided investors with the excuse to move stocks lower.  

Looking at this action plus where we stand on valuations, the playbook says that probability would indicate a consolidating market that moves sideways now for a period of weeks or even months.   Probability also would indicate that stocks have the potential now to trade in a range that we've defined in the chart above by the red trend lines.  That is roughly a range between 1,730 and 1,845 on the S&P 500.  In the short term, say the next few days/weeks,  it would seem that there is a higher probability that stocks would try to rebound into the upper bands of these resistance levels and may even test the prior market highs.  For one reason the market is now oversold enough in the short term to indicate a rally.  It remains to be seen how much the 3.5% rally since Feb. 5th has changed this short term condition.  However, the playbook also says that those upper resistance bands now form a significant level of resistance absent better economic or valuation news.  

Probability would also now indicate that there is the potential in the next few months for stocks to perhaps have a more significant correction that what we've currently seen.  Absent a significant change in the economic outlook, that correction has the potential to take us into that green trading band which is roughly between 1,600 and 1,680 on the S&P 500.  Such a correction, if it were to occur, would see the markets decline 9-15% from their January highs and 7-12% from where we are currently trading.   Again please note there is no way to tell if the markets will correct to those levels.  For all I know stocks could turn around here and head to new highs.  I'm just telling you what our work says has the highest probability of occurring.  

Tomorrow we'll discuss a bit our current game plan.

*Long ETFs related to the S&P 500 in client and current accounts.

SPY chart courtesy of FINVIZ.com

Winter Letter {Conclusion}

Today is the final installment of our 2014 winter letter that was recently sent out to our clients.

In June of 2012 when stocks were at the same levels they had seen in both 2007 and 2010, we stated: 

“NEVER IN MY INVESTMENT CAREER {now spanning over a quarter of a century} HAVE I SEEN STOCK VALUATIONS THIS CHEAP BASED ON HISTORIC PE LEVELS AND ABSENT A RECESSION OR A SIGNIFICANT ECONOMIC CONTRACTION!!!!  Either we are going to have an event that provides a significant hit to growth or stocks are presenting a buying opportunity of a generation for longer term investors.”3.

I have also written this, specifically last summer:

“Based on what we currently know, I think that stocks have annual growth potential on a total return basis {price appreciation + dividends} between 4-8% per year.  I’m writing this with the belief that stocks will not rise in straight line, I believe some years will be better than others and we could see a down year or two in the running.  In spite of that, I think there is a high probability that we will be surprised at how well stocks will continue to perform throughout the rest of this decade. I’m saying this aware of current valuations and also well aware that this kind of statement could look foolish near term if we see some sort of market correction. But remember I said that I think stocks could average between 4-8% on a total return basis for the rest of the decade.  That may not seem like a lot.  It is substantially lower than the “go-go” years that characterized the late 90’s.  But don’t overlook the compounding effect of this kind of return.  A portfolio that compounds at an 8% clip will roughly double in 9 years.  Compare that with the return on bonds now and its hard not to still find stocks attractive on a longer-term basis.  As a side note you can still receive nearly all of the 10-year’s yield in the S&P 500 plus you can get that appreciation kicker.”4. 

I see nothing going forward to change that last statement and we now know that stocks presented that buying opportunity in 2012.  Stocks may not be as cheap as they were then but neither are they expensive on a historic basis.  While we may see a bit of a bump, based on what we are seeing in the tealeaves, probability suggests that the future is bright longer term.

3.  Solas!:  Valuation {06.19.12}

4.  Solas!: Summer 2013 Investment Letter {Part III}

As of this writing Mr. English held positions in ETFs related to the S&P 500 in client and personal accounts.

Winter Letter {Disclaimer}

Christopher R. English is the President and founder of Lumen Capital Management, LLC. -A Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for private investors and also manage a private investment partnership. The information derived in these reports is taken from sources deemed reliable but cannot be guaranteed. Mr. English may, from time to time, write about stocks or other assets in which he or other family members has an investment. In such cases appropriate discloser is made. Lumen Capital Management, LLC provides investment advice or recommendations only for its clientele. As such the information contained herein is designed solely for the clients or contacts of Lumen Capital Management, LLC and is not meant to be considered general investment advice. Mr. English may be reached at Lumencapital@hotmail.com.

Winter Letter {Part III}

Another tailwind is that our politicians have finally started to play nice.  Witness last year’s tax accord and this year’s budget agreement.  Governmental fiscal constraints should likely be less of a headwind at all levels as a growing economy brings more revenue into the till.  The Federal deficit this year could be less than 5% of GDP, down from highs over 11%.  This is still too high on a sustainable basis but it is heading in the right direction.  Corporations should see record profits this year, as their balance sheets remain pristine.   This should lead to increases in dividends, more capital spending and stock buy-backs. 

Of course there are still concerns.  Unemployment remains stubbornly high.  Rising interest rates could hamper economic growth as well as a possible alternative asset class relative to stocks.  Real wage growth, especially for those in low skill industries, remains elusive and most Americans have little to no savings.  Abroad, the economies of emerging markets have been weak.  Growth in China has slowed.  Europe while improving has little room for error.  Flashpoints around the world remain problematic.  Yet perhaps the largest concern we should have is how positive many are on stocks.  It seems that much of the media and the pundit class have a much more benign outlook for equities than they’ve shown in the past few years.  While many will view this universal bullishness as perhaps a contrary indicator, I would balance that against a market, which we’ve discussed above, is more or less trading at fair value and against all that money that is still sitting in bond funds or money market accounts.  It is that money that I think will buttress any declines this year in the markets. 

I think 2014 has the potential to be a year of growth but I would also note that the last time the market saw a real correction greater than 10% was in the spring and summer of 2011.  Probability suggests that at some point we will see markets decline in excess of that.  Given the hope investors seem to have for stocks this year and given where we stand in regards to market valuations, probability would suggest that we prepare for that sort of decline at some point this year.  Our strategy may be to build up our cash reserves as per individual client risk/reward and strategic mandates as we rebalance accounts.  As always in times like these we will have the defensive pages of the playbook nearby. 

As of this writing Mr. English held positions in ETFs related to the S&P 500 in client and personal accounts.